Remember, we have had the failure of Lehman Brothers (the Global Financial Crisis), the sovereign debt issues in Europe (the European debt crisis), and in the NZ context the failure of the non-bank financial sector post-05. These crises can be expected to have a relatively persistent impact on economic activity – but not permanent. Once all is said and done, and financial stability is returned, economic activity should in turn recover.

However, if the “wedge” (inefficiency) in financial markets persists indefinitely this suggest that something else is the cause. Let’s also remember that at the same time that all this was going on financial regulation by central banks around the world has also changed! While these changes will increase the stability of the financial system – they come with a permanent cost in terms of economic efficiency … there could potentially be a persistent wedge between the return to lenders and the cost to borrowers due to these policies.

Given both happened at the same time we can’t “identify” what did what – which makes the outlook even more unclear than it usually is. However, it is important to keep all these disparate causes in mind when trying to understand what is going on.

The reality is that a lot of bad debt needs to be flushed from the system and this will severely dent bank profits for a long time. Add to that possible changes in the money creation process, new innovations in P2P lending and finance in general, and you may see that the banking sector may not be the wisest place for one’s “cash”.

Debt only impacts upon economic activity insofar as it limits lending to worthwhile projects – in that context, it is understandable that the strange actions of the ECB, and the issues in NBFI’s have had an impact on economic activity in NZ. The issue isn’t the existence of debt, its the lack of knowledge regarding where the burden of “bad debt” will fall.

Once this has been clarified, it is also clear that changes to financial regulation will have an impact – what isn’t clear at present is how much of the current “wedge” in financial markets is due to changes in regulation (permanent) and how much is due to a lack of trust and the issue of asymmetric information (persistent but temporary). In order to talk about the future, it is important to make an explict call regarding this – which is an interesting issue.